New DeFi solutions are addressing problems that plagued earlier projects, especially regarding transaction volume and liquidity. Liquidity protocols are rapidly emerging and helping to increase the total volume of crypto assets in circulation.

These projects also help users earn passive income through trading fees and staking. Although these platforms are effective, liquidity protocols are associated with several risks, including impermanent loss. This type of loss is unavoidable and common across shared liquidity protocols hosting crypto trading pairs.

What Is Impermanent Loss?

A liquidity provider experiences impermanent loss when the total value of crypto assets deposited into a liquidity pool drops below the initial value. This reduction in value only becomes real when withdrawing the assets from the liquidity pool, hence the impermanence. Before withdrawal, any loss estimated on the crypto assets in a liquidity pool remains on paper. In the long run, the losses could significantly reduce or disappear entirely depending on market movement.

Impermanent loss only happens when liquidity providers deposit crypto assets in automated market maker (AMM)-based liquidity protocols. The AMM model eliminates intermediaries in decentralized finance (DeFi), and trades deposited crypto assets directly from the liquidity pool. These pools use a constant algorithm formula to balance the ratio of tokens deposited from the buy-side and sell-side. Regardless, depreciation could inevitably lead to a loss in the asset's value in the broader market since the AMM calculation prioritizes asset proportions in the pool.

How Does Impermanent Loss Happen?

The following is one example of how impermanent loss can take place:

• A liquidity provider stakes 1 ETH (worth $1500) at the time of deposit and 1500 DAI in an AMM pool.
• After a while, the price of 1 ETH suddenly declines by 50% to $750.
• If the user held the initial 1 ETH and 1500 DAI, they have now lost 50%. While they may have earned additional DAI as a reward for providing liquidity, the amount isn't likely to offset the losses from the decline in ETH price.

The possibility of impermanent loss is the major difference between holding two crypto assets in a wallet and depositing them in a liquidity pool. These losses are 'impermanent' because the liquidity provider only realizes the loss after withdrawing staked assets. If the price of ETH goes back to 1500 DAI before withdrawal, there will be no impermanent loss.

There can also be a rebalancing problem, so if a user wants to purchase more DAI and less ETH, they might end us with more ETH (although the same dollar-value amount) than DAI, causing potential losses.

Calculating Impermanent Loss

The value of impermanent loss in each case depends on a variety of factors, including the crypto assets in the pool and the number of liquidity providers. Generally, impermanent loss is not as likely in less volatile pools, such as pools that pair ETH with a stablecoin like USDC. On the other hand, providers would have a higher risk of impermanent loss in liquidity pools with highly volatile assets.

AMMs calculate impermanent loss using a standard formula. However, liquidity providers can find an impermanent loss calculator to estimate possible losses in advance. Some impermanent loss calculators allow users to set the initial and future prices of two different assets in a trading pair and get a detailed report of potential losses by comparing different market scenarios. Users could also find calculators that help to manually set the initial deposit amount and liquidity pool ratio.

How to Avoid Impermanent Loss

While some impermanent loss is unavoidable due to the volatility in the prices of crypto assets, liquidity providers can reduce the chance and impact of such losses on their portfolios by taking the following steps:

Using Stablecoins Pairs

Liquidity providers can avoid impermanent losses via stablecoins pairs like USDC and DAI. Stablecoins have little to no volatility, which significantly reduces the risk of impermanent losses. As a result, a provider can more safely earn trading fees without fear of rapid price movements. The downside of providing liquidity using stable crypto assets is that there are no gains in a bullish market.  

Introducing Trading Fees

Trading fees can significantly offset impermanent losses. All DeFi transactions require trading fees that liquidity providers eventually share. In some cases, the profits from the trading fees are sufficient to cushion the impermanent losses. The loss generally reduces with a corresponding increase in the amount of trading fees collected.

Liquidity Pool Ratio

Some DeFi protocols use an AMM ratio of 50:50 in liquidity pools. Continuously maintaining the ratio between two assets in a liquidity pool to balance the pool's value increases the chances of impermanent loss. However, other DeFi platforms use different ratios that help reduce the possibility of impermanent loss.

Price Deviation

To avoid impermanent loss, a liquidity provider could wait for the price of a pair to return to the value at the time of deposit before making a withdrawal.

One-Currency Asset Pools

Some AMMs have a one-currency liquidity pool instead of a pool with two assets. The possibility of impermanent loss is significantly lower in one-currency pools since there is little risk involved.

Is Being a Liquidity Provider Worth It Despite Impermanent Loss?

The crypto market has always been more chaotic than traditional financial markets because of its high volatility and the risk of impermanent loss. However, being a liquidity provider is still potentially lucrative as there are more opportunities to earn passive income.

Intending liquidity providers need to perform due diligence and proper risk management on the protocols they plan to use. Whether impermanent losses result in a small or huge drop in asset prices, liquidity providers should be aware that this phenomenon almost always happens to some degree.

As many liquidity pools emerge, more providers risk impermanent losses on their assets. While admitting that impermanent losses are ever present in liquidity pools, every provider must take adequate caution and as many preventive steps as possible to reduce the chance of a loss.

Trade Peer-to-Peer (P2P) on AtomicDEX

If you're a liquidity provider trying to avoid impermanent loss, consider becoming AtomicDEX — a next-generation application that provides a non-custodial wallet, P2P bridge, and P2P DEX rolled into one app.